The Master Lease: A Case Study on How to Achieve Cashflow with Little Capital
Money. Is that the only thing holding you back from building cashflow?
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Capital seems to be the biggest determent for many investors who want to start investing into cashflow real estate. There is a solution to the dilemma of cashflow and investment capital. What is it?
A Master Lease may be that solution!
What is a Master Lease?
Dictionary.com defines a master lease as a “controlling lease under which a lessee can sub-lease a property for a period not extending the term of the master lease.”
A master lease conveys rights to the Lessee (Master Lease Investor) that help make this an ideal solution to the investment dilemma. Master Lessee gets two major rights through a master lease:
- Right to control the asset for a period of time
- Right to sub-lease the asset
These rights allow a Master Lease Investor to acquire cashflow assets with limited cash capital.
Is Now a Good Time for Master Leases?
Let us breakdown today’s investment environment. Owners can’t sell as prices are still depressed from the heights when many of them bought their houses and not all buyers can’t get mortgages yet everyone needs a place to live. This leads to growth in gross rental rates.
Growing rental rates and difficulty selling real estate is a perfect mix for implementing the Master Lease strategy with the right sellers.
Who Should is the Right Seller?
As a master lease investor, you need to get creative on who you can approach with this strategy. The beauty about this strategy is that you can approach any owner with it but there are certain owners who would be more open to the idea:
- Free and Clear out of town owners who want to sell for a specific price and cannot achieve that price in the current market. Their motivation is driven to achieve that hurdle number and may not need all the cash today and do not like renting given the headaches associated with the tenants and repairs.
- You can target owners who bought their assets at the height of the market and need to sell but cannot due to the market value being less than their original purchase price. These owners maybe motivated to accept a Master Lease contingent on it working for their debt carry costs due to the inability to refinance and not achieving the price that they want for the asset.
Types of Master Leases
The two most prevalent master lease types are:
I. A performance master lease requires the master resident to pay a percentage of the funds he receives from his sub-resident only when he receives those funds.
II. A fixed lease, on the other hand, generally requires the master resident to make payments even if he does not have a sub-resident.
There are many hybrids given that each owners has different needs. As a master lease investor you can negotiate any and all aspects of your master lease – the variable or fixed rent amount, the term, the liability for expenses, escape clauses, etc. The key is to draft your documents by design based upon your negotiations with the owner rather than by default (i.e. using a standard realtor lease).
Fears Associated with This Strategy
Many investors are more fearful of executing a long-term lease as a master lessee than they are of buying an investment property. I think this is an irrational fear since it is easier to terminate a lease than it is to get out of title so the liquidity risk is less with a Master Lease strategy.
Some investors also think that they may have to be licensed under their state’s real estate brokerage law to engage in master leasing. Usually this is not true. Licensing is generally required for property managers (with few state exceptions) because managers have a fiduciary relationship with their principal.
Perspective of a Master Lessee
Long-term secured lease without an option often acts as a stealth option, since the owner must negotiate with you to remove your lease from the property when refinancing or selling. A master lease in many ways allows you to test drive a property before deciding whether or not you might want to buy.
The master lease is a great way to get your foot in the door for future negotiations. A master lease gives you the opportunity to build the relationship that leads to future purchases and often owner financing. Don’t make the mistake of thinking that your master lease is the final negotiation. It should be the first negotiation that can lead to one or more future negotiations.
You have first payment risk to your landlord. This simply means that you still have pay the rent to the owner even if your sub-tenant stops paying rent. This liability is similar to the liability that any owner of cashflow real estate would have to the lender who gives you money to buy the asset.
You can and will have variability in cashflow associated with unexpected repairs that can lead to negative cashflow. You can mitigate this risk by conducting a home inspection prior to master leasing the investment and craving out special repair ceilings within your master lease agreement.
Landlord-Tenant court. This is something that all buy & hold investors have to deal with so welcome to the club Master Lease Investors. You can mitigate this risk by conservatively underwriting your tenants so you can weed out the good from the bad tenants.
Capital Improvements to make the unit rentable. As a master lease investor you may rent the unit that needs to be cosmetically repaired to get top market rent for the asset. Be prepared to have a few months worth of capital reserves built up prior to making a master lease investment.
Real Life Example: Strawberry Court, New Jersey
A friend, Joe , purchased a condominium unit back in 2006 but had to relocate to another location nearly 1 hour away due to easier commute to his job
The move for his job caused Joe to rent out the unit to a tenant. Joe was a part time landlord at best given his demanding Wall Street job. Over time, Joe grew tried of the tenant complaints and the unexpected repairs that arose at the unit. While the tenant always paid on time, the sheer time spent managing the tenant got too much for Joe. So when the tenant vacated the unit, Joe decided to sell the unit “as-is” instead of fixing up the damages caused by the tenant and re-renting the condo.
Joe put the unit on the market with the simple goal of breaking even. Joe received a few offers on the unit but all the offers were from investor buyers who wanted nearly a 20-30% discount from the list price. (Good Side Note: Condos are typically more illiquid than single-family homes depending on where the unit is located.) Joe was unwilling to accept those offers as it would cause him to experience a loss that he was unwilling to take. After months and lots of frustration, Joe reached out to me to see if I would be interested in buying the condominium.
I walked the unit with Joe. While walking through the unit, I asked Joe about what he wanted exactly from the offer. Joe stated that he was looking to sell the unit without taking a loss as he did not want to rent it out and take on tenant headaches. Joe was willing to be creative about how the deal would be structured and had a really good mortgage interest rate on the unit after his recent rate readjustment. I went back to my office and completed a basic market analysis with the following findings:
Market Research Findings
CMA Market Value- $175,000
Rental Value-$1,200 per month
I ran my math and approached Joe with the following offers:
Offer I- $130,000 All Cash
Offer II-$162,000 with $25,000 downpayment so that Joe could pay off his second mortgage. Joe would give me a wrap mortgage wherein he would make a 100 basis point more than his carry cost for a period of 5-years thereafter I would cash him out completely.
I reviewed the offers with Joe and explained the pros and cons for each offer. Joe needed to net $165,000 in order to not take a loss. Offer II would get Joe to that number given the additional interest rate spread along with continuing to pay down his mortgage principal for the next 5 year period. We shook on it and signed a Letter of Intent (LOI), which laid out the structure of our deal.
Lawyers can really muck up deals
I have nothing against the law profession and there are some great real estate transaction lawyers out there but at times the wrong lawyer can muck up deals. That is what happens with me as Joe’s lawyer was uncomfortable with the wrap mortgage structure given that it invoked the due on sale clause. Before you all jump down my throat, I did explain the due on sale risk to Joe before we signed the LOI.
Creativity arises when it seems that all is lost.
After the attorney sent over the kill letter, I spoke to Joe again and told him that his price was not achievable in today’s market without doing rehab to the unit or being creative on the selling terms. I then remembered the master lease strategy and I thought why not talk to Joe about it
A Master Lease became the solution that we both wanted!
I explained to Joe the idea of a master idea. I told him that with a master lease I would give him a fixed monthly payment, which would be below the fair rental market value of the unit, but I would take care of upgrading the unit and any minor repairs that arose in the unit. Joe thought about it and liked the idea of continuing to pay down his mortgage and make a small profit without taking on any of the variability and tenant risk. We had a deal.
Joe needed about $650 per month to break even on costs after we agreed on the master lease idea. I worked my math and realized that I would need to invest about $3,50 to fix up the apartment to make it rental ready and carry the property for a few months before it produced any cashflow. To make myself whole and make a profit, I wanted a 60-month lease term so that I could make my initial investment and make my target return on equity requirements. Joe agreed to the term but wanted stepped up payments so we agreed to a $770 master lease payment that stepped up about 5% per annum.
We struck a deal, and I crafted the master lease document that laid out the terms of our agreement.
I gave Joe a security deposit and the first month rent and started down my novice journey as a master lease investor. First thing that I needed to do was repair the unit to make it rental ready and I wanted to spend $3,500 which did not work out given the extent of the labor shortage in our market following hurricane sandy. I searched for over a month to get the right quote but I could not find anyone so I bite the bullet and decided to complete the work for $5,000.
My project manager, Vinnie, managed the asset and completed the rehab job within three weeks and within the newly established budget.
I thought great the construction is done, and I will be able to get a tenant right away but I mistimed the construction completion. I completed clean up of the unit for showing near the first week of new month and no tenants were out there looking for a rental. So I waited another month and give Joe another $770 while my team searched for a new tenant.
I finally find Mike. I am strict tenant underwriter so I denied a few tenants before I found an acceptable tenant in Mike. Mike rented the unit for $1,200 per month and was responsible for his own utilities. I created a new sub-leasehold interest with Mike subject to my master lease interest and I became his landlord.
Strawberry Ct Investment Summary
Cosmetic Upgrades-$4,750 (projected only $3,500)
Project Manager Fee-$1,000
Vacant Rent- $2,310 (3 months originally projected only 2 months)
Total Investment- $9,260
Gross Rent: $1,200
Payment to Joe: -$770
Net Rental Cashflow: $430
If this net rental cash floe holds up then this investment payback period including return of the security deposit through rental cashflow will be appx. 24 months. Now this is a projection and the payback period can and maybe longer if unexpected repairs or vacancy occurs which forces me to invest more cash into this investment. So what are the major takeaways from this case study for me?
*I was able to secure a projected net cashflow after reserves and vacancy of $250 per month. In the state of NJ, I cannot buy $3,000 of annual cashflow for under $10,000 investment.
*Remember projections are just that projections. Be prepared to spend money at times and do not get dejected on cost overruns. Figure out where you went wrong and correct it for the next investment. My mistake was not getting an updated quote from a contractor post sandy and rather relying on my rule of thumbs established before the construction demand surged occurred in my area.
I hope this post inspires you to be creative and not let money be a deterrent to building your cashflow wealth. I am by no means an expert on using the Master Lease strategy, but I wanted to share my experience with you the readers.
I look forward to hearing your thoughts and comments in the comment box below.
Photo: Kevin Dooley